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Topic 2 European Monetary Cooperation
reasons for cooperation:1
political: increased monetary co-operation would lead to pressure for increased political
Institutional: payment mechanism within EU would be made easier if currency exchanges
were limited
Trade: reducing exchange rate movements would further enhance the free trade area of
historical: past experiments at floating exchange rates seen as being unsuccessful.
Power: individual European countries were not major world powers, together, they were
more important
Lower interest rates and inflation rates?
Reduced amplitude of business cycle?
Policy trilemma
(can only have 2/3)
Capital mobility
Stable exchange rates
Monetary policy autonomy (ability to do it individually for your own country without looking
at your own)
chronology (moodle)
69/70: werner report
71: Smithsonian agreement, fluctuation bands widen to 4.5%
72/73: nake in the tunnel -bilateral parities withing eu could fluctuate 2.25% within tunnel
defined by dollar parities
73: European monetary co-operation fund
79: setting up of erm of ems- irish punt floated against sterling
89: delors 3stage plan for monetary union (werner mark2) Madrid summit -stage1 to start in
June 1990
91: Maastricht summit, criteria for entry to EMU agreed
92-3: Currency crisis
95: changeover to single currency published by European monetary institute
99: exchange rates fixed, euros used as unit of account and as a means of payment in financial
transactions. EMI replaced by European central bank, ECB and the European system of central
banks (escb). 11 countries took part
99: erm 2, for countries not in single currency- Greece and Denmark
01: Greece joined the single currency having been deemed to meet the Maastricht criteria
02: euro currency commenced circulation
08: ten years of the euro celebrated
10- crises! Will the euro survive?
setting up a new exchange rate system? Decide:
 what is the anchor of the system – ECU (comprises of many currencies)
 when intervention is necessary, who intervenes? – Both strong and weak
 How is intervention to be funded? – European cooperation fund
 What flexibility is to be allowed? – 2.25% (Italy 6%) around ECU central parity
 How are realignments to be handled? – mutually agree, following discussion -divergence
Operation of erm to ez (gros& thygensen)
 Initial turbulent start, 1979-83.
 Calmer intermediate phase, March 1983- Jan 1987.
 Success at last? Jan 1987- August 1992.
 Turmoil in Currency market, sept. 92- July 93
 Erm- broad bands, preparation for emu 93-98
 Erm 2- 1999, non emu members and (some) accession countries
 First 10 years of emu seen as a success
 Crisis periods showing up as weaknesses
9 currency crisis 1992 -1993
economic environment:
 Collapse of trade with Soviet Union
 Pressure on interest rates and inflation rates due to GMU
 Pressure on interest rates and inflation rates, due to gmu
 Weak dollar damaging to european competitiveness
 Deficits reducing policies in place
 German preoccupation internal problems
 Franc for policy
 Uncertainty over Maastricht ratification process
10 currency crisis
 speculative attack against the erm of ems
 attempts to defend the erm using high interest rates and interventions
 Italians first to be devalued
 After ‘black Wednesday’ sterling left the system
 Finnish and Swedish unilateral pegs suspended
 Irish punt eventually devalued by 10% at end January 1993
 These measures were not sufficient- eventually in summer 1993, the bands were
widened to 15%
This compromise was seen as the end of the erm, and the end of the emu project
(ended up delaying by about 3 years)
11 Reasons for the crisis
Unsustainability of currency pegs, where capital is mobile (the policy trilemma)
Self- fulfilling currency attacks
Pegging policy too costly in terms of unemployment, high interest rates etc
German political and monetary union, and franc fort policy -the assymetric shock problem
12 lesson from the currency crisis
 intermediate exchange rate regimes are inherently unstable- either have fully fixed
or fully floating
 pegged, but adjustable exchange rate regimes may be inconsistent with the free
flow of capital -limits on capital flows are necessary
 speculative attacks on pegged but adjustable exchange rate regimes inevitable
 you can’t win against the market
 early adjustment to exogenous shocks required
13 European monetary union
 managing the German current account surpluses
 anchoring to a low inflation country would give low inflation
fiscal discipline needed- stability and growth pact common banking supervision
discussed, but not adopted – revisited during crises period
14 Euro : the early years
euro accepted as major world reserve currency, an alternative to the dollar during periods of
dollar weakness.
 Could it take over as the major international reserve currency if dollar weakness continues
 Monetary policy for the euro zone countries centralised at the European central bank in
15 euro the early years, ctd
 worries as to whether this central bank will be independent or whether it will be over
influenced by member governments
 like the Bundesbank, it has its core objective monetary stability, with growth in output
and employment only secondary objective
 stability and growth pact deficit limits exceed by those who had insisted on its inclusion
(Germany and France) but no fines imposed
16 ecb and monetary policy (moodle)
17 euro the first 10year
initial period: euro depreciated against dollar, going from $1.11 per euro to close to parity in
July 1999 from a high of $1.18
below parity with the dollar for three years, 2000-2, reaching lows of .83, despite
intervention by world central banks, and interest rate increases by the European central
extended period of dollar weakness in 2007 on
difficulties for euro zone exporters to dollar area, and those trying to attract us tourists to
Europe – particularly difficult for Ireland
‘currency wars’?
18 policy tool: interest rates
 increase if there are inflationary pressures
 reduce in times of recession
one policy fits all? Too early an increase in interest rates because of inflationary
pressure in centre countries exacerbates problems in slow growing peripheral
countries and makes banking problems worse
19 (look at graphs on moodle)
20 Could the euro project fail?(pre-crisis viewpoint)
 Countries have too much political stake in the project
 No mechanism for leaving the euro has been outlined (going from strong currency to
 The European institutions are strong
 The economic consequences of going it alone are profoundly negative
 The new central bank has had strong leadership and the euro has been accepted as
major world currency
21 could the euro project fail? (pre-crisis viewpoint except blue line)
 history says that all exchange rate regimes are temporary
 lack of fiscal coordination means problems of deficit countries affect all
 devaluation option attractive
 over-rapid absorption of new member states into the euro could undermine
confidence and lead to pressure for looser monetary policy
 political reluctance to support highly indebted
countries (piigs – Portugal Ireland Italy Greece
22 euro at 10 (2008)
 ‘resounding success’
 Self-congratolary tone
 Some clouds ahead acknowledged
 Financial stability not mentioned (De Grauwe.2013)
23 international crisis to euro crisis:1
 was slow to follow other central banks in reducing interest rates in response to the
crisis- remained worried about inflation for longer
 interest rates at zero
 extended special lending facilities to European banks in trouble (slow increment to
reacting to the next crisis)
 Maastricht deficit criteria suspended
Quantitative easing policy belated adopted
24 international crisis to euro crisis: 2
 ‘super mario’ – all that needs to be done will be done
 Greece was danger of defaulting on its own soverign debt, helped by ecb and imf,
despite ‘no bail-out’ clause’ of original emu treaties
 Grexit a real possibility 2011,2013
 Sovereign borrowing costs highly variable in crisis
 Piigs in trouble
25 Monetary arithmetic in a monetary union
 Country with their own currency can monetise the debt (sargent and Wallace) to
avoid default
 Countries without their own currencies may not, meaning the default premium is
large, once crisis occurs (DeGrauwe, Sims)
 Ecb, by statue may not lend to the governments, the ‘no monetary financing’ clause
26 international crisis to euro crisis
 ‘quantatitive easing’ in uk and us
 Ireland and Portugal joined Greece in needing help, spain Italy in difficulties
 Emergency liquidity measures, meant to be short term, extended
 Eventually qe in ez
27 no bailouts allowed!
Pre-crisis, a Greek promise was considered as good as a german promise, so many german
and French banks held Greek sovereign debt, as it had a slight premium over german debt
Once crisis hit, capital flight from piigs to centre countries, undermining banking system
Partial write down of Greek debt
28 from crisis to crises
 liquidity crisis
 banking crisis
 sovereign debt crisis
 political crises
contagion and fears of contagion
irrational exuberance to excessive caution?
29 ecb and the crisis
 European financial stability facility created and (eventually) allowed to buy sovereign
bonds on the secondary market
 Securities market progamme (2010) allowing ecb to buy sovereign debt in primary
and secondary markets- two german members of ecb resigned
 Long term re financing operation (11-12)
30 what needs to be done?
 Completing the banking union;
Breaking the ‘doom loop’ between banks and their sovereigns;
Ensuring ez-wide risk sharing for Europe wide shocks;
Cleaning up the legacy debt problem
Coordination ez-level fiscal policy while tightening national-level discipline;
Advancing structural reforms for a better functioning monetary union
euro ongoing
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